Editor's Note

US investors who've participated in the great China stock market boom may not know it, but they have a silent partner-the Communist Party of China.

The biggest and best-known Chinese companies are majority-owned by the Chinese government. It and the ruling party handpick officers and directors, divvy up market share, and, in the case of strategic industries like oil and transportation, make sure corporate goals are in sync with national policy. In China, companies must navigate government-imposed price controls of key goods and services like salt, gasoline, and utilities.

"The state has all kinds of levers and tools to influence these companies," says Dr. Christopher McNally, research fellow and China specialist at the East-West Center in Honolulu and editor of a forthcoming book, China's Emergent Political Economy: Capitalism in the Dragon's Lair.

And the state and the Communist Party work together hand in glove.

We reviewed Securities and Exchange Commission documents filed by several of the leading Chinese companies whose market value has ballooned in China's recent stock-market boom. Their executive suites are full of people who ran these industries when they were government-controlled, and in each case, longtime party members play leading roles.

"All the personnel appointments go through the party," says Dr. McNally. "You have to be a good bureaucrat, well-connected, and loyal to the party."

Take China Life Insurance (NYSE: LFC), whose market capitalization now tops that of MetLife. Director Zhou Ying holds the official company title of chairman of the Communist Party Disciplinary Committee at China Life. He got his start more than 25 years ago in the China Communist Youth League Beijing Committee, followed by a succession of party and government posts that also included experience in state-owned banks.

Or consider PetroChina (NYSE: PTR), which by some measures became the world's most valuable company following its recent public offering in Shanghai. Its vice chairman, Jiang Jiemin, who also serves as general manager of the state holding company that controls PetroChina, was a deputy provincial governor of Qinghai Province and a member of the provincial party committee, the annual report says. Mr. Jiang apparently spans all three power centers-party, government and company. Nice work, if you can get it.

Meanwhile, over at rival oil and gas producer Sinopec (NYSE: SNP), chairman Chen Tonghai and vice chairman Zhou Yuan have high-level positions with both Sinopec and its state holding company. Both have long histories as party officials in the petroleum industry and as government officials of two provinces-Mr. Chen in coastal Zhejiang and Mr. Zhou in the oil-rich Xinjiang autonomous region.

In fact, an article last October in Chinascope magazine reported that the ten largest Chinese companies listed on the New York Stock Exchange at the time all had chairmen, chief executive officers, or presidents who were also Communist Party officials.

This one-hand-washes-the-other form of state capitalism is the product of a massive reorganization of the Chinese economy undertaken earlier this decade. Enterprises in key industries were put under the control of State-Owned Assets Supervision and Administration Commissions (SASACs).

The SASACs in turn run state holding companies, which own upwards of 60% of the shares of the big Chinese public companies whose names have become household words among investors.

And the party and government aren't shy about using their power, either. In 2004, the top three Chinese telecom companies (China Telecom, China Mobile, and China Unicom) played boardroom musical chairs, exchanging top executives upon orders from their SASAC, Chinascope magazine reported.

And in its 2006 annual report China Life says the following about its relationship with China Life Insurance (Group) Company (CLIC), the state-owned holding company that owns 68.4% of China Life's shares:

"We are controlled by CLIC, whose interests may conflict with those of our other shareholders.CLIC, which is wholly-owned by the Chinese government, will...effectively be able to control the composition of our board of directors and, through the board, exercise a significant influence over our management and policies."

That may include, the report continues, issues such as dividend policy, share issuance and mergers and acquisitions. Translation: even big Western institutions that own these shares have little clout.

Or take this statement from China Mobile's 2006 annual report:

"The PRC government encourages orderly and fair competition in the telecommunications industry in Mainland China. In particular, the PRC government has extended favorable regulatory policies to some of our competitors, such as China Unicom, in order to help them become more viable competitors to us."

Sounds like the powerful ministries that used to pick winners and losers in Japan in the 1980s, doesn't it?

This is not, of course, your father's Chinese Communist Party, which distributed millions of little red books with quotations from Chairman Mao during the Cultural Revolution.

"Overall the way they manage these companies is very capitalistic," says Dr. McNally. "Profitability counts."

"Most of the time, in day-to-day operations, they are not different from other companies," adds Dr. Steve Tsang, China region head of Oxford Analytica and a professor at St. Antony's College at the University of Oxford. "They don't always listen to what the government says."

For example, he says that price controls on gasoline have made sales in mainland China unprofitable for Sinopec, which has the dominant market share. "The more they sell, the more they lose," he explains. That's why he says the company hasn't exactly opened the spigots, especially as crude prices rose. Result: unofficial rationing has been reported in some parts of the country.

But that could change, if a price squeeze or supply shortage creates "social instability"-the party and government's worst nightmare. "If it becomes a major issue, they will dance to the tune," Dr. Tsang observes. (The government recently authorized a 10% rise in fuel costs and paid Sinopec a big subsidy last year to cover losses.)

That may be why even long-time China bull Robert Hsu, editor of China Strategy, steers clear of some large state-owned companies like PetroChina. "I don't like the corporate governance," he says.

There are public Chinese corporations, like computer manufacturer Lenovo Group, that are not majority state-owned, although these entrepreneurial companies can be more difficult for Americans to invest in.

And the state-owned behemoths have turned out to be tough competitors, reporting strong earnings gains and, of course, skyrocketing share prices. US investors who've owned them either directly or through funds have profited handsomely over the past couple of years. Many of them probably couldn't care less who really owns and controls companies whose stocks have doubled or tripled in price.

This may indeed be one of those cases where issues like this don't matter-until they do.